Old Bull Shows Its Age

At the start of 2013, investors were worried about the uncertain U.S. and Chinese economies, about the prospect of a withdrawal of Federal Reserve stimulus and about signs stocks were getting overpriced. The Dow Jones Industrial Average responded with an 11% gain at this time last year, on its way to a 26% full-year binge.

Now, investors are worried about pretty much the same things. And the Dow? It is down 3% this year.

Why the big shift in stock performance? Although it doesn’t look like it on the surface, investors and analysts think some basic things are changing. Many see 2013 as an exceptional year, not a harbinger of things to come. Even if stocks finish 2014 with gains, a growing number expect indexes to endure a pullback of more than 10% at some point.

“It is going to be a bumpier ride,” said Jim Dunigan, chief investment officer at PNC Wealth Management, which manages $127 billion for its clients.

Part of the problem is last year’s gain. Stocks rise 10% to 12% in the average year, including dividends and not adjusting for inflation. But the S&P 500 gained 30% (32% including dividends) in 2013, its biggest advance in 16 years. The Dow’s gain was its biggest in 18 years.

Many analysts warned last year that investors, full of hope for 2014, were simply pulling returns ahead. Now the market is paying the price. While corporations and the economy are doing as well as investors had hoped, the news isn’t dazzling enough to push stocks still higher.

And there is more to it than that. Some of the vague fears investors dealt with last year, such as the reduction in Fed stimulus or the slowdown in China, have become reality. The lackluster stock market could be what one gets in a world where China is slowing its breakneck growth and the Fed is gradually ending the program that pumps billions of dollars into financial markets each month.

Maybe this year, with its ups, downs and uncertainties, is a taste of what is to come.

“We saw some outsize returns last year,” said Bob Browne, chief investment officer at Northern Trust Corp., which oversees $880 billion in Chicago. “We think we are in an environment that can support a 6-8% return a year, including dividends.”

Investors “are going to get that in a very lumpy way,” and after last year, this year’s return could be closer to the low end than the high end, he added.

“You had very significant Fed accommodation and now it is less so,” said Mr. Dunigan of PNC. Stocks gradually now will have to shift to being supported more by economic fundamentals and less by Fed stimulus.

“In my experience, those transitions are sort of sloppy,” he said.

Some of the tectonic plates under the market also are shifting.

Bit by bit, stocks have become more expensive compared with the profits of the corporations that issue them. High stock prices make would-be buyers wary, just like high prices for anything. At these prices, the goods, in the form of corporate sales and profits, have to be very high quality.

There are many ways to gauge stock prices and they mostly tell the same story: Stock prices are well above average. While they aren’t yet at extremes, they are getting closer.

FactSet, for example, compares stock prices to companies’ earnings from operations for the past 12 months. That figure today is 16.4, up from 14.5 a year ago. That is well above the historical average of 14. Stocks topped out at this level in 2007 but in 2010, they returned to this price-to-earnings level and kept rising.

Other p/e calculations based on other earnings measures tell similar stories: P/e ratios are high but not outrageous. Stocks have sometimes topped out with p/e ratios at this level; at other times they have kept rising.

Ned Davis Research recently looked at yet another way to gauge this sort of thing. It used Fed data to calculate how much money is sitting in cash on the sidelines, available to be shifted into stocks.

Cash and other liquid assets represent a little over 22% of household financial assets, close to the low of 22% hit at the stock-market peak in 2007 although not yet close to the low of 19% when stocks hit their high in 2000. When cash was this low in the past, stocks have risen, on average, 2% a year, Ned Davis Research calculates.

Foreign purchases of U.S. stocks, however, are well below 2007 and 2000 levels, the study finds, suggesting that foreigners still could buy more U.S. stocks. U.S. corporations, big buyers of their own stocks, retain plenty of cash to keep buying. And bondholdings still are a bit above average, meaning investors could shift money to stocks from bonds.

Although Fed policy still supports stocks, Mr. Davis concluded, stock prices are high and both institutions and households are heavily invested, leaving less available cash. While he didn’t predict imminent trouble, he added his voice to the generalized warning that there are “risks that we could see a substantial pullback this year.”

After five years, the bull market is no longer young. It probably isn’t dead yet, but is likely in for more of the ups and downs that have characterized this year. Barring a return to the irrational exuberance of the 1990s, stocks could find it hard to repeat 2013’s exceptional returns, and they could be in for a pullback.